Earn 6% a year on safe investments

by Cliff D'Arcy on 12 July 2011  |  14 comments
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With cash earning pathetic returns and shares too risky for most, these bonds look tempting.

You don't need me to tell you that the past few years have been an ordeal for British savers and investors alike.

With the base rate stuck firmly at a historic low of 0.5% since March 2009, savers have been slammed by the lowest savings rates in living memory.

Safe savings and shaky shares

At least savers were protected from losing their capital, thanks to absolute guarantees from our government, plus the safety-net provided by the Financial Services Compensation Scheme (FSCS).

Indeed, during the past four years, no UK-based savers have lost a penny in UK-regulated banks and building societies. Alas, while savers have held onto their cash, investors have lost billions as share prices crashed and businesses failed.

The third way: bonds

With cash deposits offering meagre returns (especially these 71 awful accounts) and shares too scary for many, is there some halfway house between saving and investing?

Yes, there is: corporate bonds.

A corporate bond is an IOU issued by a company. This debt pays a fixed income throughout its existence, known as a yearly 'coupon'. A bond is issued at a preset price, usually £100, known as 'par' and is repaid at the end of its life at par. Therefore, when you buy a bond and hold it until maturity, this debt will be repaid at par (unless the company defaults, of course).

In short, during its fixed life, a bond pays you a regular income and then returns your lump sum at the end. One way to invest in corporate bonds is to spread your risk by buying into a corporate bond fund, which invests in a wide range of company bonds. Despite charges on these funds being quite steep, they were the most popular type of fund for private investors during the financial crisis.

Buying bonds made easier

Over the past 1½ years, it's become much easier to pick, buy and sell bonds without the help of a professional fund manager. That's because the London Stock Exchange launched ORB, its electronic Order book for Retail Bonds, in February 2010.

In most cases, these bonds can be traded in batches of £1,000 or £100, and all are free from the 0.5% stamp duty applied to share purchases. Even better, ORB bonds with five years or more before maturity can be bought inside tax-free ISAs, keeping the taxman's mitts off your coupons.

Show me the income

Many insurance and investment companies have come up with complicated 'guaranteed' products aimed at providing higher incomes to cautious investors. However, many of these hybrid schemes, known as 'structured products' have come under attack for their complexity and lack of transparency.

Hence, given a choice between buying a quality retail bond and a structured product, I'd plump for the former almost every time. Let's review some retail bonds on offer via ORB (full list) - to get started, here are six bonds issued by UK household names:

Source: FT Money, 9/10 July

The first bond shown (issued by insurance giant Aviva) pays a yearly coupon of 6.125% a year until November 2036, which beats all savings accounts hands down. This £100 bond could be bought last Friday for £93.04, at a discount of £6.96 to its redemption price at par. This gives the buyer a current yield of 6.58% a year.

However, the first four bonds can all be bought below par (£100), so they will produce capital gains if held to maturity. This extra gain is shown by their higher redemption yields. However, the last two bonds (from Tesco and Vodafone) trade above par. These will produce capital losses if held to maturity, hence their lowered redemption yields.

It's also worth noting that the Legal & General bond matures at on the last day of this century, so it will likely outlive you and me both!

Now for the wealth warnings

Although these six companies are strong businesses in their own right, their bonds are not risk-free. They may be less volatile than shares, but they are not guaranteed in the same way as cash. Indeed, no corporate bond is covered by the FSCS, as cash deposits are.

Even so, these companies are good credit risks, and it is likely that their shareholders would have to be entirely wiped out before these big businesses defaulted on their bonds.

Before investing in bonds of any kind, you must understand the following risks:

• Default: Owners of corporate bonds lose out when companies fail to pay coupons and/or redeem bonds at par. When issuers default, bond owners can lose 100% of their investment.
• Inflation: The rising cost of living eats into the fixed income produced by bonds. Thus, high inflation (like today's RPI of 5.0% a year) is bad news for bonds not held to maturity.
• Interest rates: When interest rates go up, bond prices go down, and vice versa. With the base rate at record lows, bond prices are likely to start falling in 2012/13. However, if you hold bonds to maturity, 'rate risk' isn't so much of a worry.
• Liquidity: Some bonds are easier to buy and sell than others, making them more 'liquid'. In times of market crisis, getting sensible prices for illiquid bonds may be nearly impossible.
• Concentration: As with shares, you need to diversify -- spread your money around -- when buying bonds. Don't end up with one huge bond holding in your basket.
• Compensation: Corporate bonds are not covered by the FSCS, so you have no government safety-net when issuers default.

In summary, with cash earning poor rates of interest and shares up and down like a yo-yo, can you find room in your portfolio for high-income investments such as retail bonds?

More: Start saving for a brighter future | Earn 50 times as much savings interest | The scary truth about shares